Loans may put you even deeper in debt

High costs, undeserved profits and the exploitation of vulnerable consumers are high on the list of government’s increasingly harsh and vocal criticisms of the financial services industry.

It is becoming increasingly evident that one of the many reasons people do not save or do not save enough is indebtedness, particularly if their debt has extremely high interest rates and all sorts of add-ons, such as expensive credit life assurance.

It should be remembered that in probably the vast majority of cases debt is self-inflicted.

Nowhere is the debilitating cost of debt more evident than in the unsecured personal loans market, which the broader financial services industry has entered.

One of the interesting things is the use of the term “unsecured”, which is the excuse for charging interest rates in the region of 30 percent – legal, but in my view the stuff of loan sharks.

The even more excessive charges of monthly loans with interest rates of up to 60 percent is just horrendous, and they should be substantially reduced by law.

“Unsecured” means that an asset, such as a house, is not used to provide security for the loan. However, these loans are still “secured” in the sense that in most cases you need a job and/or a provable and sustainable income flow in order to be granted a loan. You will also be forced to take out credit life assurance, which will pay out for a limited period if you are retrenched and cannot make the repayments. So this is hardly “unsecured” debt in the broader sense of the word.

On top of this, if the banks and life assurance companies that are in the unsecured loans market are applying the National Credit Act properly to prevent reckless lending, the risk the loan poses to them should be reduced dramatically.

This week, I report on a case where, no matter which way you look at it, the interest and other costs seem to be shocking – but you be the judge – see “What costs can do to a loan: two products compared”, below.

My view is that if the borrower replaced the Old Mutual loan with the Capitec loan, the person did not need the bells and whistles provided in the first place in the Old Mutual debt consolidation product, which came at a shocking additional cost.

There is a good reason for Capitec’s coming from nowhere to become the name most people mention at dinner tables as the bank with which to do business: its products are simple and are priced competitively – points that come across in our reader’s letter.

Let’s get back to the crunch issue: we are our own worst enemies.

Most personal loans are made to finance current or past bad spending habits – spending on wants rather than on needs, from buying a new BMW instead of a second-hand VW Golf to buying a swanky pair of shoes for R1 500 instead of basic footware for R300.

Borrowing in order to buy something that depreciates in value is a big no-no. Granted, sometimes such spending cannot be avoided because the item is a necessity, such as a motor vehicle, even a second-hand Golf, to get to work, or medication in the event of a serious illness. But instant gratification is a problem in South Africa, and it drives debt, particularly personal loans.

July was National Savings Month. As part of its efforts to mark Savings Month, Old Mutual published its Retirement Monitor and a Saving & Investment Monitor, which revealed that 64 percent of those surveyed (and these were employed people) spend everything they earn.

This is understandable at the lower end of the income scale (79 percent of those who earn less than R3 000 a month say they spend everything they earn), but it is more difficult to understand higher up the scale (41 percent of those who earn more than R40 000 a month).

We, as a nation, need to learn to budget properly so that we:

* Spend only on what we need;

* Save a percentage of our income (at least R10 but preferably more than R20 in every R100) for well-defined medium- to long-term objectives;

* Build up an emergency fund equal to about three months’ income; and

* Limit borrowing to finance emergency spending; or an asset that we require to generate an income, such as a motor vehicle; or an asset that will appreciate in value, such as a home.

Look at it this way: if you save, you will earn interest on your money, you will be able to negotiate a discount for paying cash and you will avoid borrowing money. You will in most cases save yourself much more than half of the total costs by saving and paying cash instead of borrowing. This in the end means you will be able to buy other things far sooner and you will not be burdened by debt – and debt is a real burden.

WHAT COSTS CAN DO TO A LOAN: TWO PRODUCTS COMPARED

Reader H says a family member opted for a debt consolidation product from Old Mutual called My Money Plan (MMP). The total debt she owed at the time was about R50 000.

The loan amount was inflated through repeated disbursements, which the client understood as “rewards for regular payment”.

Credit life assurance, which amounted to about R350 a month, was packaged into the deal.

The total cost of the loan was about R162 000, with an interest rate of between 27 percent and 29 percent (depending on the meaning of the fine print) and repayments of R2 700 a month over 60 months.

The client subsequently obtained a loan from Capitec to settle the Old Mutual loan (still about R50 000 after about 10 months). The Capitec loan has a total cost of R68 000, with interest of 22 percent over 31 months. The monthly instalment is R2 200, and credit life assurance is provided at no additional cost.

The cost difference of almost R100 000 on an essentially similar loan of R50 000 is staggering. The R100 000 is equal to the borrower’s annual salary.

Old Mutual responds

MMP is very different to the Capitec product, which would be better compared to an Old Mutual personal loan, Stuart Marshall, chief executive of Old Mutual Finance (OMF), says.

The total repayment of R162 000 for MMP cannot be compared with the total repayment of R68 000 for the Capitec loan, because “there is only one upfront cash advance to the customer under the Capitec loan, whereas MMP includes several additional monthly and annual cash advances over the term of the loan.

“MMP is offered to customers who want to be debt-free, but who often get into trouble again after consolidating their debts, either because they lack effective budgeting skills or because their periodic need for cash drives them to take out additional loans and incur more initiation and administration fees,” he says.

Marshall says MMP has the following features:

* It consolidates debt by paying creditors on behalf of the borrower.

* Payments are made for up to 12 “events” that have to be paid annually, such as school uniforms, university registration and car services.

* The borrower is allowed to access a small sum of money at a selected date during the month so that he or she can survive until payday.

* There is a six-monthly cash-back bonus incentive to encourage the payment of instalments on time. In 2011, OMF paid back more than R30 million to customers as rewards.

* The annual and monthly cash amounts paid to the borrower are factored into the instalment, which remains constant for the duration of the loan term, irrespective of interest rate changes. The payments attract interest only from the dates on which they are advanced.

* Interest rates are regulated by the National Credit Act (NCA), are risk-related, and are determined by a customer’s credit profile at the time of application. The annual and monthly cash amounts paid to a customer must be taken into account when considering the instalment on a MMP and the total cost to the customer, Marshall says.

The objective of the cash amounts is to “wean customers off crippling short-term loans that entail paying back the loan amount, interest and administration fees, as well as an initiation fee”, he says.

A typical bad money habit is a cycle of “one-month loans”, in which a loan is taken out for one month, repaid and then a new loan taken out (with another initiation fee), Marshall says.

The initiation fees stipulated in the NCA are R150 for the first R1 000 and then 10 percent up to R1 000 plus VAT. This means that short-term lenders are permitted to charge R171 (including VAT) on a monthly loan of R1 000, plus annual interest of 60 percent and a monthly administration fee of R57 (including VAT), resulting in a payment of R1 268 after one month or an effective annual rate in excess of 300 percent, he says.

The credit life assurance incorporated in MMP covers the debt in the event of death, disability and retrenchment. Borrowers have a 12-month grace period on retrenchment, and if they do not find employment within 12 months, the full debt is settled, Marshall says.

HEALTH WARNING

You may well be in financial difficulty if you are about to take out, or you already have taken out, an unsecured personal loan, because you do not have a credit record that permits you to take out a loan at lower interest rates.

If this is the case, you need to take a close look at how you can cut your spending, because the interest you will pay on the unsecured loan could make your financial situation even worse.

Unsecured debt includes credit card debt. If you are not repaying the full outstanding balance on your credit card every month, this is another sign that you are in financial distress.